Explain the effect on the average lives of sequential-pay structures of including an accrual tranche in a CMO structure

What will be an ideal response?

The effect of an accrual tranche is to decrease the average lives of the other tranches at the expense of the accrual tranche. Background information on sequential-pay CMOs and more details on the effect of an accrual tranche are given below.

The first CMO was created in 1983 and was structured so that each class (or tranche) of bond would be retired sequentially. Such structures are referred to as sequential-pay CMOs. A CMO is created by redistributing the cash flow (both interest and principal) to the different tranches based on a set of payment rules. Each tranche receives periodic coupon interest payments based on the amount of the outstanding balance at the beginning of the month. The disbursement of the principal, however, is made in a special way. A tranche is not entitled to receive principal until the entire principal of the preceding tranche has been paid off. Although the priority rules for the disbursement of the principal payments are known, the precise amount of the principal in each period is not. This will depend on the cash flow, and therefore principal payments, of the collateral, which depends on the actual prepayment rate of the collateral. An assumed PSA speed allows the cash flow to be projected.

The principal pay-down window for a tranche is the time period between the beginning and the ending of the principal payments to that tranche. Tranches can have average lives that are both shorter and longer than the collateral, thereby attracting investors who have a preference for an average life different from that of the collateral. However, there is considerable variability of the average life for the tranches even though there is some protection provided for each tranche against prepayment risk. This is because prioritizing the distribution of principal (i.e., establishing the payment rules for principal) can effectively protect the shorter-term tranches against extension risk. This protection must come from somewhere, so it comes from the other longer term tranches that benefit from being protected against contraction risk.

The payment rules for interest provide for all tranches to be paid interest each month. In many sequential-pay CMO structures, at least one tranche does not receive current interest. Instead, the interest for that tranche would accrue and be added to the principal balance. Such a bond class is commonly referred to as an accrual tranche or a Z bond (because the bond is similar to a
zero-coupon bond). The interest that would have been paid to the accrual bond class is then used to speed up or pay down of the principal balance of earlier bond classes. Thus, the average lives for the other tranches become shorter because of the inclusion of the accrual bond.